Home-Brew Your Own Housing Fund

by Will Ashworth | November 19, 2012 7:00 am

Home-Brew Your Own Housing Fund

It’s official: The housing recovery is most certainly under way.

A number of homebuilders — including PulteGroup (NYSE:PHM[1]) and Hovnanian (NYSE:HOV[2]) — have seem shares run up by triple digits this year, and housing data just keeps getting better. Plus, last week, Home Depot (NYSE:HD[3]) announced third-quarter results that were more than satisfactory and upped its guidance for all of 2012.

The economy certainly could use some good news, and this appears to be just the ticket.

Investors interested in playing the recovery could buy one of the ETFs that track the housing market, such as the SPDR S&P Homebuilders ETF (NYSE:XHB[4]) or iShares Dow Jones US Home Construction (NYSE:ITB[5]) fund. But if you want something that’s still diversified but a little more concentrated, consider home-brewing your own housing ETF of sorts by buying these five stocks from five different sectors:

Services: Lowe’s

I mentioned Home Depot (NYSE:HD[3]) in the opening paragraph, and although my first pick comes from the services sector, I’m going to go contrarian by opting for Lowe’s (NYSE:LOW[6]), whose financial picture at the moment isn’t nearly as pretty.

Lowe’s withdrew its $1.8 billion offer[7] to buy Rona (PINK:RONAF[8]) in September amid opposition from Rona’s board and the Quebec government. However, with Rona’s CEO stepping down Nov. 9, institutional investors are clamoring for both sides to get back at the negotiation table and hammer out a deal the provincial government can live with.

Lowe’s currently has 31 stores in Canada compared to 180 for Home Depot. Acquiring Rona’s 80 big-box stores (23 are in the process of closing) would instantly make it a more serious competitor north of the border.

With an enterprise value 8.3 times EBITDA, it’s a much better value than Home Depot, and its current 2% dividend yield is slightly better, too.

Industrials: A.O. Smith

What’s a house without a water heater? A.O. Smith (NYSE:AOS[9]) makes them — with and without tanks — in the U.S., Canada, China and India.

I love Smith’s business model[10] because it manufactures its products primarily for domestic consumption. That means most of its manufacturing in China is meant for Chinese customers, and the same is virtually true everywhere else it does business — including the U.S.

In October, AOS announced excellent third-quarter results and raised its full-year earnings forecast to between $2.85 and $2.95 per share — a 19% increase over 2011. Its Chinese business is really booming, growing 22% in the quarter thanks to new products, additional distribution and market share gains. Its profitable growth in China helped increase operating profits in the rest of the world (outside North America) by 41% in Q3 to $12.7 million. North America, which represents 73% of its revenue, saw operating profits increase 64% to $50.7 million.

It’s a great business that you can own for far less than General Electric (NYSE:GE[11]). This is my second-favorite pick of the bunch, only behind …

Financials: Berkshire Hathaway

Berkshire Hathaway (NYSE:BRK.A[12], BRK.B[13]) bought Deere (NYSE:DE[14]) stock in the third quarter. That is a company to own in almost any portfolio.

Only with Warren Buffett’s company, you get about a thousand other holdings as well — once you’ve bought Berkshire Hathaway, you really don’t need many other stocks.

In addition, Buffett won an auction at the end of October to buy $1.5 billion in residential loans through Residential Capital LLC.

These are two clear indications the Oracle of Omaha thinks the worst is behind us. I’m inclined to agree.

Technology: Hubbell

If you do a quick search of Progress Lighting products carried at Home Depot, you’ll get a list of 2,789 lamps and other lighting products available for sale. Progress is a division of Hubbell (NYSE:HUB.B[16]), a Connecticut-based company specializing in the manufacture of electrical and electronic products for a broad range of non-residential and residential construction.

Hubbell’s lighting products business (which includes 15 brands, including Progress) is part of its electrical segment, which accounts for approximately 70% of overall revenue, with the remaining 30% from products related to the transmission of power.

While not growing revenue faster than 7% a year over the past decade, Hubbell has been able to grow operating income by 13% at the same time, leading to a total annual return for shareholders of 10.1% — 390 basis points higher than the S&P 500.

Slow and steady wins this race.

Consumer Goods: Tempur-Pedic

Tempur-Pedic (NYSE:TPX[17]) is down 53% year-to-date and sits 72% off its five-year high of $87.43, reached on April 18 of this year.

How the mighty bed manufacturer has fallen.

Tempur-Pedic’s growth came to a crashing halt in 2012 as consumers put the brakes on buying thousand-dollar beds. Investors abandoned ship. Not even its announcement Sept. 27 that it was acquiring its rival Sealy (NYSE:ZZ[18]) for $1.3 billion (including debt) could stop the slide — although it got an initial bump, its stock is off more than 8% in less than two months.

For those who have followed the bed and mattress business for any length of time, none of this comes as a surprise; this industry is as volatile as they come.

Despite slowing sales, Tempur-Pedic has made money every year in the past decade. On an adjusted basis, it expects to earn $2.55 in 2012 after adding back the taxes for repatriating foreign earnings and transaction costs related to the Sealy acquisition. If you include the one-time costs, it expects to earn $1.85 per share, or $118 million — slightly more than half of 2011’s earnings — on $1.4 billion in revenue. Its profits will bounce back.

In the meantime, TPX shares haven’t been this low since early 2010. It’s not without risk, but the other four will do a nice job of counteracting any potential short-term downside.

As of this writing, Will Ashworth did not hold a position in any of the aforementioned securities.